Paychex (PAYX, Financial) has paid uninterrupted dividends since going public in 1988. While the company held its dividend flat during the financial crisis, it has otherwise increased its dividend every year since the mid-1990s and currently yields 3.5%.
Paychex has a very durable business model that throws off predictable free cash flow. We believe its dividend is very safe and offers at least average growth prospects, making it a good fit for our Conservative Retirees dividend portfolio.
Let’s take a closer look at the business.
Business overview
Paychex was founded in 1971 and provides a range of payroll, human resource, and benefits outsourcing services to over 590,000 small and medium-sized businesses. It offers a wide range of services including payroll processing (e.g. calculate, prepare, and delivery employee payroll checks; prepare payroll tax returns; collect and remit client’s payroll obligations, etc.), retirement services (e.g. 401(k) plan design, recordkeeping, and plan management services), insurance (e.g. group health insurance, health care reform, workers’ comp, etc.), and a fully outsourced human resource solution (e.g. on-site personnel, employee handbooks, etc.). Essentially, Paychex helps businesses outsource non-core administrative services in a cost-effective manner so they can focus on their strengths.
Approximately 61% of Paychex’s revenue is derived from payroll services (includes a growing portfolio of standalone services – expense management, applicant tracking, time and labor), with the remaining 39% from human resource services (e.g. retirement, insurance, human resources).
Business analysis
The services Paychex provides to businesses are mission-critical – payroll taxes must be correctly calculated and paid on time; insurance policies must conform with health care reform; proper records must be kept for 401(k) plans; and more.
As a small business owner, you want these jobs done correctly and efficiently. These aren’t tasks you want to lose any sleep or energy over. With fewer resources compared to larger companies, outsourcing these administrative tasks, which are constantly evolving as government regulations change, is usually more efficient.
With 50+ years of operating history, a large direct sales force, numerous indirect sales channels (50% of new core payroll clients are referred by existing clients, CPAs, and banks), and substantial market share, Paychex is the trusted brand of choice.
Paychex has dominant market share positions in its key businesses. The company is #1 and #2 in payroll services for small and medium-sized businesses (Paychex pays one in every 15 private sector workers in the U.S.); #1 in retirement services recordkeeping (as measured by number of plans); #23 in insurance services with more than 140,000 H&R covered lives; and provides HR services to more than 31,000 clients with over 858,000 worksite employees.
As long as customers’ administrative needs are being met with quality service at a reasonable price, they have few reasons to switch vendors. Their employees also become familiar with Paychex’s software (about 90% of PAYX’s mobile app usage comes from its clients’ employees who are doing things such as accessing their check stubs and W-2 forms), raising switching costs. As a result, Paychex’s client retention rate reached a new record high (82%) during its most recent fiscal year.
Paychex has also evolved to offer clients a larger scope of services compared to many smaller competitors. Going back just 10 years, Paychex’s business was 100% payroll services. However, the company now offers an array of human resource services (39% of revenue), which leverage the information gathered in Paychex’s base payroll processing service. Human resource services competitors that lack payroll services must depend on vendors like Paychex to power their solutions, putting them at a disadvantage.
Paychex’s broad product portfolio offers simplification and convenience for customers, but it also helps lower their costs in some cases. For example, Paychex can pool together its customers to increase their purchasing power for insurance products.
With no debt and over $900 million in cash on the balance sheet, Paychex can also acquire products to fill gaps, maintain the most fully integrated technology and service available in the marketplace, remain entrenched with its customers, and expand its growth opportunities. For example, Paychex recently acquired Advance Partners, which serves the temporary staffing industry. Paychex previously had no exposure to this market but can now access the 3 million employees it has.
Finally, it’s worth mentioning that Paychex also earns interest income from investing client funds collected but not yet remitted to applicable tax ore regulatory agencies or to client employees. Paychex is a safe dividend stock that would also see some benefit if rates ever rise.
Despite the scale, regulatory expertise, service breadth, switching costs, and brand advantages enjoyed by Paychex, this is still a fragmented marketplace with fairly low barriers to entry.
Key risks
Unlike many other businesses, Paychex is somewhat refreshing in today’s macro environment because it has no overseas exposure, is not sensitive to commodity prices, and has no currency risk. It is most sensitive to the U.S. labor market, which has been improving.
However, as a technology company, Paychex is at somewhat greater risk of disruption than many other businesses because the pace of change tends to be faster.
Investors seem to have two primary concerns with Paychex – the lack of growth available in the company’s core payroll services business and competition from new entrants such as Zenefits and Gusto (formerly known as ZenPayroll).
Regarding growth, the payroll services market is rather mature. However, it continues growing at a low-single digit pace. More importantly, Paychex has successfully expanded its portfolio to include numerous human resource services. These businesses account for a significant part of Paychex’s sales mix (39%) and have consistently grown at about a double-digit pace. Their market shows no signs of slowing down.
The company also offers various accounting and financial services (e.g. cloud-based accounting, payment processing, etc.) to businesses but notes in its annual report that “these services are in their infancy.”
The takeaway is that Paychex has expertise in introducing (or acquiring) new products needed by small and medium-sized businesses, and its existing distribution channels are very effective at quickly scaling up new services. We expect the company to continue finding growth opportunities adjacent to the payroll services market. With over 10 million addressable businesses in Paychex’s geographic markets, there should be plenty of opportunity for continued growth.
New entrants pose a greater concern to us as they have made a strong case for themselves with users. Technology (e.g. the cloud) is accelerating the rate of change in the industry, and start-up costs are increasingly insignificant. Newer software companies typically have products that offer better user experiences, lower costs, and greater innovation compared to large incumbents such as Paychex.
Zenefits is the most newsworthy rival and was founded in 2013. The company’s private market valuation reached more than $4 billion over the summer of 2015, despite expectations of generating up to $100 million in sales this year.
Zenefits runs a very different business model than Paychex. It provides free, cloud-based solutions that reduce human resource paperwork and provide a single place to manage payroll, health insurance, and other systems. Zenefits makes money by acting as an insurance broker and collecting a commission on the health insurance coverage that businesses purchase from health care providers. However, it also launched its own payroll processing service in November 2015, reducing its dependence on partners such as Paychex.
Like many startups, Zenefits has hit some bumps that could endanger its future. A Wall Street Journal article from November 2015 noted that the company is “falling short of its aggressive revenue targets,” has frozen hiring in certain departments, and has reduced pay for some executives. Regulators have also provided headwinds, arguing that the company is illegal because its free software constitutes a gift, which isn’t allowed in the health insurance business.
Like many tech startups, Zenefits is not likely profitable and, depending on how growth shakes out in the coming years, might not even survive. Fidelity Investments marked down the value of its investment in Zenefits by 48% during the third quarter of 2015 (it invested in May 2015).
On the payroll side, Gusto has emerged as a strong new entrant. Gusto is much cheaper than Paychex and provides a more pleasant user experience. It also recently added human resource services to significantly improve the scope of its offering.
Paychex can combat new entrants in several ways. First, it can use its $900 million in cash to acquire them or invest in similar functionality to stay relevant for its customers. Since Gusto and Zenefits emerged several years ago, hundreds of imitators have cropped up that Paychex could pick off.
The company is also investing in its software to stay “good enough” for customers not to switch. Roughly 80% of Paychex’s clients now have an online connection to them – accessing reports, using mobile apps, processing their payroll. Its new Paychex Flex solution also received favorable reviews by PC Magazine. Paychex will continue investing in cloud-based technology and mobility applications to improve the user experience.
Perhaps most importantly, Paychex has strong brand recognition and trust in the market. Payroll and human resource services must be working correctly 100% of the time. Until Gusto and Zenefits establish a longer track record, many of Paychex’s customers are less likely to jump ship. However, they could push for reduced pricing in future contract negotiations.
Until we see signs that Paychex is starting to struggle with profitable growth, we believe the highly fragmented nature of the market, secular growth in human resource services outsourcing, and strong brand and sales channels maintained by Paychex will keep the company chugging along.
Dividend analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Paychex’s dividend payment appears to be very secure with a Safety Score of 81, even despite the company’s relatively high payout ratio.
Over the last four quarters, Paychex’s dividend has consumed 80% of its earnings and 72% of its free cash flow. These payout ratios are on the higher side of dividend stocks we prefer to invest in and leave the company with less margin of safety and typically lower dividend growth rates. The business needs to be very stable and have a clean balance sheet to justify high payout ratios (Paychex does).
Looking at longer-term trends in payout ratios provides additional perspective. As seen below, Paychex’s payout ratios have increased from about 50% in 2005 to 70% to 80% today. This means that dividend growth outpaced earnings growth, which is not sustainable. Overall, the company’s higher payout ratios mean that future dividend growth will need to be driven by earnings growth.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
While Paychex’s payout ratios are higher than we like, the business is very stable. During the financial crisis, we can see that the company’s sales actually grew by 1% in 2009 and only fell by 4% in 2010. The stock also outperformed the S&P 500 by 12% in 2008. Business customers lay off employees during tough economic times, but they still require Paychex’s mission-critical services.
Source: Simply Safe Dividends
Since Paychex primarily delivers its services over the internet, it operates with low fixed cost. The company’s scale leverages these costs and allows Paychex to earn very strong returns on invested capital – signs of an economic moat.
Source: Simply Safe Dividends
Not surprisingly, Paychex throws off substantial free cash flow each year. With a client retention rate in excess of 80%, the company has great visibility.
Source: Simply Safe Dividends
Finally, Paychex’s balance sheet is in excellent condition. The company has no debt and over $900 million in cash and investments. The company has plenty of flexibility to acquire complementary products, return more cash to shareholders, and reinvest for growth.
All things considered, Paychex’s 3.5% dividend yield appears to be very safe. While the company’s payout ratio is higher than we like to see, this risk is mitigated by Paychex’s predictable cash flows and pristine balance sheet.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Paychex’s dividend Growth Score is 65, suggesting that the company’s dividend growth potential is above average. Paychex has paid uninterrupted dividends since 1988 and compounded its dividend at a mid-single digit pace over recent time periods.
Source: Simply Safe Dividends
Since the company’s payout ratios are relatively high (70% to 80%), we believe future dividend growth will align with earnings growth – somewhere in the mid- to high-single digit range. Paychex also has the balance sheet (no debt) to continue growing its dividend regardless of economic conditions.
Paychex held its dividend flat during the financial crisis but has otherwise increased its dividend each year since the mid-1990s. While it’s not close to being a member of the S&P Dividend Aristocrats Index, it sure has been a reliable dividend payer.
Valuation
Paychex trades at 23x forward earnings (22x excluding net cash) and offers a dividend yield of 3.5%, which is in line with its five-year average dividend yield of 3.5%.
With 6% to 9% earnings growth potential, the stock could deliver a total return between 9% and 12% per year going forward. While it’s not a bargain, Paychex’s high quality and consistent fundamentals make it appear to be trading at a reasonable price today.
Conclusion
Paychex is a sticky, time-tested business that provides mission-critical services for its customers. It shares many traits with some of our favorite blue chip dividend stocks and has an extremely reliable dividend. While we will continue monitoring the competitive landscape, we expect Paychex’s strong brand, deep sales channels, broad product portfolio, regulatory expertise, switching costs, and flexible balance sheet will keep the company relevant for many years to come.
